Executive Summary
Although so many financial and economic models take as a fundamental assumption the idea that we are all rational human beings, the emerging research from the field of behavioral finance clearly illustrates this is a false assumption. In reality, we have some pretty strange financial behaviors, that do not appear to be at all consistent with a purely rational decision-making process. Fortunately, the world of behavioral finance is showing us that at least some of our irrational behavior occurs in a consistent manner that we can predict, so while our actions may not be rational at least they can be anticipated. But that in turn begs a fundamental question: when faced with a client making an irrational financial decision, is the rational (for the planner) solution to try to change the client to be more rational as well, or to change the recommendation to fit the client's irrational behavior?
The inspiration for today's blog post comes from some ongoing discussions I've been having with other planners about how to develop financial planning recommendations for irrational clients. But it's not just about what the emerging research on behavioral finance tells us that people do; it's also about what YOU are supposed to do ABOUT it. In general, I'm finding that planners seem to fall into one of two camps: either the "proper" way to deal with irrational clients is to show them how they are being irrational and help them to see the error of their ways so that they will self-correct the behavior, or you are supposed to adapt your financial planning recommendations to arrive at a solution that will work in spite of the client's irrational behaviors.
It's actually a pretty difficult challenge for the client-centric financial planner. The idea of following the latter path - to adapt your recommendations to the client's irrational behavior - just feels... "icky" to many, and is outright anathema to some. How could you, the professional financial planner, possibly make a deliberate decision to offer a recommendation that is not the "optimal" one based on all the analysis and data available? For instance, would you ever recommend an illiquid investment to someone, simply because you wanted it to be harder for them to make a hasty irrational decision to sell it in a panic? After all, almost by definition, if the client is acting irrational, they are making "sub-optimal" decisions that are not in their best interests, and recommending a sub-optimal solution would seem to just exacerbate the problem. How can you be a professional and cater to such client tendencies? How could it be responsible as a planner to deliberately recommend a solution that takes a client down a less-than-optimal path? Or simply put, if you're a rational professional, how can you NOT give rational-based recommendations?
If you're going to go down such a path, though, you'll have to convince the irrational client to stop being irrational, for which the best prescription right now seems to be "show the client how he/she is behaving irrationally, and let them self-correct the behavior." To say the least, this can be far more difficult in practice than it sounds, though. For instance, if there's one thing I've learned in my brief time being married, it's that if I think my beloved wife is acting in an irrational manner, it rarely improves the situation to point this "fact" out to her at the time the "problem" is occurring. Perhaps, maybe, we can have a conversation to reflect on how one of us was behaving irrationally, long after the fact, but even then it still doesn't necessarily mean the same thing won't happen next time. And in a client situation, your time is far more limited; the time that you meet with your client to try to "fix" their irrational behavior is the same meeting at which you're trying to get them to adopt a rationally recommended solution at the end. In other words, you're trying to package together re-education, re-training, and a rational recommendation into a pretty small window of time.
But once again, if you don't think you can convince the client to just stop being irrational by pointing out their irrationality to them, what else is a planner to do? The next step would seem to be right back where we started; if you can't change the client, you have to change the recommendation to fit them, instead. In some cases, this may not be too difficult; for instance, the emerging field of choice architecture has a great focus on looking at how we can better guide client behavior (in finance and many other areas) to the outcome we want them to select, simply by being cognizant of how the decisions are presented in the first place. A classic example is changing savings plans to occur automatically and let people opt out, instead of not-saving by default and asking them to opt in; as a result, savings behaviors come out dramatically improved. In other words, it's a way to use a client's irrational behavior to their own advantage. So maybe catering to a client's irrational tendencies isn't always bad, and sometimes you can take advantage of predictably irrational behaviors for a client's own good?
So what do you think? How do you handle these challenges in your own life and with your own clients? Do you try to "fix" the irrational behavior, or "fix" the recommendation to fix an irrational world? Is one solution more "professional" than the other?
I believe that it is vital that financial planners account for clients’ behaviors, whether rational or not. Frankly, I think many planners are already creating recommendations that are at times “sub-optimal” without a conscious recognition they are doing so. There is a reason we get to know our clients; get to know their feelings about risk, their goals and their personalities. This allows us to help them on a deeper level than giving them the best modeled choice (which has a high likelihood of not happening anyway.)
In fact, if we choose to only recommend the rational, optimal model; we must remove the planner from the equation. A web-based program with a few inputs can figure this out and spit back an answer.
Furthermore, planners are not immune to acting irrational. We are people after all. We are impacted by emotions like everybody else. We may even act more irrational at times because we have a belief in our rational abilities and don’t recognize how emotions are impacting us.
I don’t think it is possible to explain to someone through logic how they are being irrational. Irrationality is emotion-based. Emotions do not respond to logic. Humans are capable of rationalizing away any reality presented to them if it causes emotional discomfort.
I believe that in the investing area the way to deal with irrationality is to encourage people to focus on the effect of valuations on long-term returns. All irrationality in the investing realm evidences itself in the form of either overvaluation or undervaluation. So by dealing with valuations you are dealing with all irrationality even though you may not have specifically identified any of the particular irrationalities.
Not that it’s easy making the case about valuations!
Rob
Nice overview. But it raises a question:
If you adjust your recommendations, how much responsibility do you incur? After all, you are not psychiatrists, correct? So your “sub-optimal” but more seemingly appropriate recommendations could leave me worse off, than if this time your client acts rationally.
As a client who acts somewhat impulsively (my preferred word for your description), I still want your best advice, even if I choose not to take it. In the end, it’s my life. If you were to advise me trying to readjust my behavior, it could backfire on both of us fairly easily.
BTW, “begging the question” does not mean “raises the question”. It means not answering the question, by avoiding it.
I just found your site, and am enjoying the reading. Thanks.
John
Really great blog!
To expect people to act with absolute rationality is, in itself, irrational. If we were so rational, I wonder whether we’d need any advice. Surely no one would be overweight, or smoke or drink too much alcohol, to pick 3 examples. Helpling someone lose weight would be as simple as telling them to eat less because it would improve their health – something they would accept and effortlessly act on, based on a single robotic calculation.
There is also, dare I say it, some naivety in assuming that the financial planner’s recommendation represents perfect rationality. Aside from the planner’s own human frailties, there’s also the potential impact of uncertainty and randomness. The planning process is structured and based on rationality but we’re not quite talking about the laws of physics here!
All the same, I can’t help siding with John Beaty when he says he wants to hear what the best advice is, even if he doesn’t follow it. I find myself in a quandry, potentially contradicting myself …
Going back to my diet example, asking someone to go from a sendentary lifestyle and 7,000 calories a day to 30 minutes exercise and 2,500 calories per day isn’t really going to happen in just one day. Setting out a series of steps is more practical … I’m just not sure financial regulation makes the same accommodation. Perhaps it should!
That saves me. Thanks for being so snesible!
Isn’t this the great value of our services in the first place? For those of us that manage our clients’ investments as a part of our overall financial planning services, we can discuss rational recommendations with our clients, get their buy-in during non-emotional times and then serve as a “firewall” for lack of a better term when the spats with irrational decision making come calling.
It’s not to say that we’ll fix the behavior, (although it does improve over time in my experience) but I like to think that’s why we’re there . . . to serve as an advocate for our client’s best intentions.
Great conversation as always!